China hikes rates to cool investment bubble

Interest rate hikes likely first of tightening measures to come

HONG KONG (MarketWatch) - The Chinese central bank said Thursday it was raising its key interest rates in an effort to slow explosive loan growth and cool investment in the world's most populous country.

It was the People's Bank of China's first rate hike since October 2004 and comes against a background of a rapidly expanding economy which has been fueled by low interest rates and easy investment terms. Those conditions have raised concerns that an investment bubble could be inflating.

The rate hike will take the 1-year benchmark rate, which applies to nearly half of all loans in China, to 5.85% from 5.58%. The People's Bank of China also lifted its other official lending rates.

"The increase in the lending rate is aimed at further strengthening the fruits of macro controls and keeping solid momentum for the economy to grow in a continuous, rapid, coordinated and healthy manner," the bank said in a statement on its web site.

China was widely expected to hike interest rates after first-quarter economic data, released a week ago, revealed exploding loan growth and excessive investment. Figures released on the National Bureau of Statistics Website showed fixed-asset investment rose 27.7% in the first quarter of 2006. The Bank of China's move comes after first-quarter GDP rose a stronger-than-expected 10.2%. Analysts' consensus had been for GDP growth of 9.7%.

"The economy is overheating," said Andy Xie, Morgan Stanley's chief economist for Asia. "They're trying to cool lending and investment."

Li Jin, an assistant professor of finance at Harvard Business School, speculated that China may have raised interest rates to pave the way for a currency revaluation.

"It might be a sign that the government expects the yuan to appreciate," said Li Jin, an assistant professor of finance at Harvard Business School. "I don't want to speculate too much, but this would be the right time for the Chinese government to do that. China is trying to prepare for that scenario."

Xie noted that although this was the first major rate hike by central China authorities in almost two years, municipal governments have already taken initial steps to rein in overinvestment. The Shenzhen special economic zone, an industrial region in southern China bordering Hong Kong, is implementing changes designed to slow credit growth. One step being considered is boosting the size of down payments required on home loans to 40% from 20% currently.

Xie added that raising rates is a superficial approach to a more serious problem. "This is a band aid approach," he said. "As long as there's the expectation of currency appreciation, there will be a lot of money going to China, and causing overheating. This does not deal with the fundamental problem."

The yen rallied immediately after the news. It was recently up 0.7% leaving a dollar worth 113.94 yen.

Earlier in the week, Chinese policymakers had said they would take steps to cool excessive investment. "We must strengthen adjustments in fixed-asset investment and tighten the throttle on land and credit," the National Development and Reform Commission (NDRC) said Tuesday in a paper published on its Web site.

In the first quarter of this year, total loan issuance was half of the quota set by Beijing for the entire year. China's money supply is growing at about 19% a year, according to government data.

Analysts expect more macroeconomic cooling measures in the near future.

"There will be more coming," said Xie. "There will be measures on land supply, since that's very vital to this tightening."

Besides real estate, other sectors tipped for intervention include industrial production linked to steel and glass, according to a policy paper.

The other interest rates raised by the central bank include the 1-3 year rate, which will rise to 6.03%, the 3-5 year rate, which will climb to 6.12% and the rate for loans over 5 years, which will be raised to 6.39%.

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